Stress Tests For US Banks Unveiled

The US Treasury has released further details on these so-called stress tests. So now we have a somewhat clearer picture on how these tests will be conducted.

The exercise is currently limited to banks with assets greater than $100 billion, which represent roughly two-thirds of aggregate U.S. banks assets. However, eligible U.S. banks with assets below $100 billion may also obtain capital from the Capital Purchase Program.

The capital assessments will be carried out under 2 defined economic scenarios over a 2-year time horizon (2009-2010), a baseline scenario and a more adverse scenario (assuming unemployment rate rises above 10% and home prices fall by another 25%).

The assessment of the firm’s capital and the size of any potential needed additions to capital will be determined by the supervisors, based on factors including: the inherent risks of the institution’s exposures and business activities, the quality of its balance sheet assets and its off-balance-sheet commitments, the firm’s earning projections, expectations regarding economic conditions, and the composition and quality of its capital.

A bank that requires additional capital will be required to issue a convertible preferred security to the U.S. Treasury in an amount sufficient to meet the capital requirement determined. Each institution will be permitted up to 6 months to raise private capital to meet this requirement, and would be able to cancel the capital commitment to the Government without penalty.

The convertible preferred securities will be converted into common equity shares on an as-needed basis. Financial institutions that issued preferred capital under Treasury’s TARP 1.0 will have the option of redeeming those securities and replacing them with the new convertible preferred securities.

The process will be completed as soon as possible, but no later than the end of April.

The Treasury has already clarified that the result of the test will not be “pass” or “fail,” but how much capital does this bank need in order to meet the credit needs of its borrowers? We suspect that the banks having Tangible Common Equity (TCE) below 3%, such as Bank of America (BAC), Citigroup (C), Wells Fargo (WFC), U.S. Bancorp (USB) and PNC Financial Services Group (PNC), to name a few, will be perfect candidates for further capital infusion from the Government.

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